The U.S. Economy 2016, Part I: The Fundamentals Of Oil And Possible Oil Market Moving Items

Summary

There is currently a glut of oil production versus consumption of about 2 MMbpd (EIA).

Two major oil forecasters-- the EIA and the IEA - disagree about how soon the oversupply situation will correct itself.

The large amount of hedging at historically low oil prices recently may put a cap on oil prices for the near future.

Banks may be motivated to push the price of oil upward. That may be hard in the current environment; but it could happen.

Using the US Trade Deficit as a gauge, low oil prices do not appear to have been a boon for the US economy.

Click to enlarge

Oil prices have fallen from highs of roughly $109/barrel in the summer of 2014 to recent lows of $26.05/barrel in mid-February 2016. As of this writing on March 18, 2016 Nymex WTI is selling for approximately $39.44/barrel. What is the shorter and longer-term outlook?

Two major oil price, production, and demand forecasters are the IEA and the EIA. The forecast from the IEA is in the chart below.

As readers can see, the supply and demand curves arrive at the same point at sometime in Q3 2016. This disagrees significantly with the forecast from the EIA for the World Liquid Fuels Consumption and Production Balance below. In this case, the supply and demand lines don't approach each other until Q2-Q3 2017. Since the EIA estimates are a bit more recent, it may be better to give them more weight.

As readers can see, non-OPEC production has already started to fall, while OPEC production is still expected to keep rising from 38.18 MMbpd in 2015 to 39.25 MMbpd in 2016 to 40.02 MMbpd in 2017. Total World Production growth is expected to slow from 93.30 MMbpd in 2014 to 95.74 MMbpd in 2015 to 96.44 MMbpd in 2016 to 96.70 MMbpd in 2017. In comparison Total World Consumption is still expected to grow at a good pace from 93.70 MMbpd in 2015 to 94.85 MMbpd in 2016 to 96.06 MMbpd in 2017. As readers can see production is still expected to lead consumption at the end of 2017. However, the difference will be much less, and the difference, if the forecast is correct, will be low enough to pressure oil prices significantly to the upside (see chart below).

The green line above represents the expected change in the WTI price from the previous year. That means you have to think about the above chart. The rise of the green line into 2016 may seem a positive; but it only means the WTI price is down about -17% from the average price in 2015. It is not up year over year. The rate of decline has merely lessened. Thus, the average WTI price at the start of 2017 is expected to be very close to the average WTI price in 2015. Thereafter, it is expected to rise slowly throughout the year. In other words, the WTI price of oil is expected to rise slowly from the end of the spring in 2016 through the end of 2017.

The chart below shows the EIA forecast for oil prices for the next two years.

This price forecast (the red line) shows oil prices remaining below $40/barrel until mid 2017. Naturally, there is a huge amount of leeway in the forecast (the dashed green lines are 95% confidence lines).

Some of the price may be mediated by global oil inventories. These are expected to grow by 1.6 MMbpd in 2016 and by 0.6 MMbpd in 2017. Remember China is strategically increasing its oil reserves. Global consumption of petroleum and other liquid fuels is expected to grow by 1.1 MMbpd in 2016 and 1.2 MMbpd in 2017. By comparison, the world production will still grow, but it will grow by only 0.70 MMbpd in 2016 and 0.26 MMbpd in 2017. This is a total of 0.96 MMbpd in production growth for the two years. The forecast numbers allow for demand growth to outstrip production growth by 1.36 MMbpd over those two years. That would allow the gap between production and consumption to close to 0.64 MMbpd of greater production. This is a small enough number that it should pressure the price of oil upwards. Remember the OPEC surplus production capacity is expected to be down to 1.55 MMbpd by the end of 2017.

A lot of the drop (or lessening of growth) is expected to come from US oil production. The chart below shows this is already happening.

Again readers want to be careful how they read this chart. The blue columns only indicate year-over-year change. In other words, the rate of growth has been lessening so far. It has only been negative growth in production for one month on the above chart (the most recent month). The brown line on top indicates the overall US oil production rate during the time plotted. The expected negative bent to the brown line for the next two years should again help the situation. This has been taken into account in the above statistics. I just wanted to confirm for readers that the "glut" is beginning to ease in some areas.

A second part to the US oil and gas companies' problems is hedging. According to Business Insider, Adam Longson of Morgan Stanley (NYSE:MS) will probably cap WTI crude prices at $49 per barrel due to "rampant hedging." Longson's analysis is below:

"Producer hedging is rampant in the $40s. Both anecdotal evidence from our trading desk and CFTC [Commodity Futures Trading Commission] data support this. The CFTC producer short position reached new highs after the Jan lows, partly from distressed producers being forced to hedge. However, this latest uptick has not been confined to distressed producers. In our conversations, we are seeing healthy appetite from mid and large cap Permian producers as well. These producers are happy to hedge $45-50 in calendar 2017 and even high 30s/low 40s in 2016 given light hedge positions. Much of this hedging is just current production for now."

Longson sees WTI trading in the $25-$45 per barrel range in 2016.

There is one further argument. Jim Cramer and some others think that one way out of the oil and gas development companies' current financial problems is for the oil and gas companies to recapitalize themselves in much the same way that the banks did in 2009 (and later). This might let them survive their current fiscal problems until the price of oil rebounds to a level that is profitable for most oil and gas companies. This might also save the banks that lent oil and gas companies money some heartache about bad loans.

With the above in mind, it is reasonable to consider that banks and other big commodity traders could drive the price of oil up with their HFT programs. They might drive the price as high as $65-$70 per barrel. Remember short squeezes should be relatively easy to engineer in the current negative environment for oil. The $65-$70 level is a level that would make many oil development companies profitable. That way the oil companies might be able to save themselves (or at least many of them might be able to). That would relieve many problems for the banks and for Wall Street. It is just possible it could happen.

Longson's argument that the high amount of hedging at low values may have put a temporary cap of about $50 per barrel on WTI oil is a logically valid one. However, money often determines what happens in the markets. It could be monetarily good for a lot of people for oil prices to go higher even in the current glut. For instance, the writers of put options would not have to pay off on lower puts if the price of oil rose high enough. Hence, the odds that this may happen are higher than they would otherwise be. I wouldn't plan on this happening, but I would not completely discount the possibility either. Discounting this possibility could be very costly.

In sum, it appears that the oil production glut will go on well into 2017. We could see upticks in oil prices due to the summer driving season. We could see upticks due to scares during the hurricane season (roughly June-October). Then too there are the geopolitical risks. Any negative news about such risks seems sure to be blown out of proportion by those who want oil prices to go up. We could see upticks due to engineered short squeezes. All told, we are likely in for a very volatile oil market for the rest of 2016 and into 2017. It might be smart to avoid the whole thing if you are an investor. If you are a trader, you may wish to take advantage of the volatility.

A vehicle a lot of stock traders use to invest in or short oil is the United States Oil ETF (NYSEARCA:USO). A two-year chart of USO below provides some technical direction for an investment or trade.

Click to enlarge

Readers can see that the downtrend has been a long one, but it appears to be bottoming. USO's recent break above its 50-day SMA line is a bullish sign. Of course, the decreasing volume is a sign that this move upward may be weakening. Investors and traders need to be very cautious.

As for the effect on the US economy, one would have to say we have seen a lot of the negative effects so far. Oil and gas companies and the service companies associated with them have been hurt badly. A lot of oil and gas companies will see the last of their good hedges run out after the summer of 2016 (hedges at $80+ per barrel). They will not likely be able to replace these. That may put many of them into bankruptcy. That would be bad for those companies.

It would be bad for the banks who lent them money. Many people are raving about how good low oil prices are for the US economy. However, the US still had a huge trade deficit of -$45.7B in January 2016. This is even worse than it seems because we are paying a lot less for oil. We have replaced part of the oil trade deficit with a larger deficit in other areas (see chart below).

When oil prices rebound, it will then be hard to do away with the new "other goods" trade deficit. That means the US Trade Deficit may expand significantly. When you ask whether low oil prices have been good for the US economy, I think you have to say that they have been an overall negative in the longer term. The US oil and gas industry has been hurt. Other industries have been hurt by cheaper imports. New "cheap" imports have made inroads in new areas in the US. The long-term Trade Deficit will have grown appreciably when all is said and done. Those thinking of low oil prices as a saving grace for the US economy are just fooling themselves.

NOTE: Some of the above fundamental fiscal data is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.